Winners and losers from the introduction of
continuous variable price trading: Evidence
from the Riga Stock Exchange
Joseph P. Kairys Jr.
a,*, Raimonds Kruza
b, Ritvars Kumpins
c aFaculty of Business and Management, Vytautas Magnus University, S. Daukanto 28, LT-3000 Kaunas, Lithuania
bRiga Stock Exchange, Riga, Latvia cParex Bank Corporation, Riga, Latvia
Abstract
This paper examines the impact from changing the trading mechanism at the Riga Stock Exchange (RSE). All three trading lists that once traded in a daily call auction followed by ®xed price trading were transferred to a mechanism where the call auction is followed by continuous variable price trading sessions. We ®nd that for stocks with high liquidity before the transfer, trading volumes more than doubled, while for stocks with low liquidity before the transfer, trading volumes fell to less than a quarter of their pre-transfer levels. The functions of a stock market in providing price discovery and a secondary market for shares were eroded for more than half of the securities listed.
Ó2000 Elsevier Science B.V. All rights reserved.
JEL classi®cation:G15; G12; G14; G18
Keywords:Emerging markets; Market microstructure; Liquidity; Trading systems
www.elsevier.com/locate/econbase
*
Corresponding author. Tel.: +370-7-32-36-39; fax: +370-7-20-38-58. Present address: Depart-ment of Finance and ManageDepart-ment Science, Faculty of Business, University of Alberta, 3-20H Business Building, Edmonton, Alberta, Canada T6G 2R6. Tel.: 0675; fax: +1-780-492-3325.
E-mail address:[email protected], [email protected] (J.P. Kairys Jr.).
0378-4266/00/$ - see front matterÓ2000 Elsevier Science B.V. All rights reserved.
1. Introduction
The issue of market microstructure has gained increasing attention in recent years. Advances in technology have led to the development of highly sophis-ticated computerized trading systems, which can both improve liquidity and reduce trading costs. The choice of the most appropriate trading mechanism has become an increasingly important issue not only for ®nancial markets in developed economies, but also for emerging markets where there is a need to build the ®nancial infrastructure. Emerging markets are evaluating and im-plementing new trading systems, and they are making considerable investments in improving their microstructure. A question of interest for both ®nancial economists and investment practitioners is whether these substantial invest-ments in improving the market microstructure have positive value and long-term bene®t.
In the transition economies, which are emerging from decades of central planning and all of its associated ineciencies, there is an especially important need to ensure that the trading system chosen for their stock exchanges will enhance market liquidity. Without liquidity, prices are not informative, and thus their stock markets cannot provide price signals to both users and sup-pliers of capital. In many cases, one can observe that the form of a ®nancial market has been imported to a transition economy, but the function remains largely stillborn due to an absence of both buyers and sellers in the ®nancial markets.
Furthermore, the market costs that arise from insucient liquidity and depth are one of the most signi®cant impediments to the well functioning, reliability and attractiveness of these markets. Illiquidity, as measured by the absence of continuous order ¯ow in a given stock, implies that there is an extreme mismatch between the available buyers and sellers at a given point in time. Hence, a large buy or sell order may have to be dismantled into dierent transactions or even executed in other markets, e.g., the over the counter (OTC) market, and traded at dierent prices. Limited depth in a market may result in a terrible trade experience since the execution of the ®rst fraction of the large order will adversely aect the subsequent orders. Consequently, only the presence of large number of orders (market orders, quotes, limit orders) with the bid and ask prices close to each other indicate a reasonable level of market liquidity and depth.
Vilnius, and Riga have all introduced some form of continuous trading with variable prices.
Whereas Tel Aviv developed its own continuous trading system at variable prices, the stock exchanges in Prague, Warsaw, Vilnius and Riga have all initially adopted electronic single call auction trading systems developed in co-operation with the FrenchBourse de Paris.1Since then, the trading mecha-nisms for these latter four markets have followed a similar evolution. For all ®ve of these markets, the most liquid stocks were moved from a ®xed price call auction to continuous trading at variable prices in a series of transfers. Only in Riga, however, have all stocks listed on the exchange been moved to contin-uous trading at variable prices.
The introduction of continuous trading in Tel Aviv has been studied by Amihud et al. (1997). They ®nd that the liquidity of continuously traded stocks increased and resulted in a positive and permanent price appreciation of the stocks transferred to the new trading method. In reporting on the adoption of continuous trading at variable prices, theRiga Stock Exchange(1998b)Annual Statistical Survey ± 1997 reports, ``Introduction of continuous trading at variable prices was an event of paramount signi®cance in 1997. It facilitated an increase in turnover and improved the stock exchange competitiveness among East European stock exchanges.'' Our ®ndings con®rm that the stocks which already enjoyed the greatest liquidity in Riga before the transfer saw their average trading volumes more than double. However, the stocks with low li-quidity before the adoption of continuous trading at variable prices saw their trading volumes fall to less than a quarter of their pre-transfer levels.
We are unable to determine whether the transferred stocks experienced a price appreciation as a direct result of the adoption of the new market mi-crostructure, since the transfer of stocks to the new trading method in Riga occurred in only two discrete batches or ``events''. In Tel Aviv, in contrast, stocks we transferred in a series of 17 batches, so that Amihud et al. (1997) were able to apply an event study methodology and calculate cumulative ab-normal returns.
Furthermore, unlike Tel Aviv, a large number of the stocks listed on the Riga Stock Exchange (RSE) trade infrequently so that estimation of the market model and calculation of market model residual variance is not feasi-ble. For the stocks with low liquidity before the transfer to continuous trading at variable prices, the average stock traded in 34% of the trading sessions in
1
Riga. After the transfer to the new trading mechanism, this same group of stocks traded in only 22% of the trading sessions.2
In Riga, the holders of the most liquid stocks before the transfer experienced a gain, as the ease with which they can liquidate their holdings has increased. The owners of less liquid stocks, however, now ®nd it even more dicult to sell their holdings, thereby making these stocks even less attractive to potential investors. We argue, therefore, that there is a group of losers as well as winners from the adoption of continuous trading at variable prices. A question for further research to explore is what trading mechanisms are most appropriate to enhance the liquidity of thinly traded stocks in emerging markets?
We believe that the value of the present study is twofold. First, Riga pro-vides the only example among all these markets of moving all listed stocks to the new trading mechanism. The other four exchanges have limited the use of continuous trading at variable prices to only the more liquid stocks listed on their exchanges. Second, we raise the issue that although the introduction of continuous trading at variable prices may bene®t the majority of shareholders in an emerging market by improving the liquidity of their shares, there may also be a group of shareholders who lose from the ``improved'' trading mechanism.
The rest of the paper is organized as follows. Section 2 describes the trading mechanisms on the RSE. The data and empirical results are pre-sented in Section 3. The implications of our ®ndings are discussed in Section 4. We oer our concluding comments and suggestions for further research in Section 5.
2. Trading mechanisms on the Riga Stock Exchange
With the collapse of the Soviet Union in 1991, Latvia regained its inde-pendence and began the transition from a centrally planned economy to a market economy. In 1993, the RSE was ocially founded anew, and a search was begun for the most appropriate trading system to use. The stock exchange model selected was a computerized, order driven system developed in co-op-eration with the French Bourse de Paris, and similar systems have been suc-cessfully implemented in Poland, the Czech Republic, and Lithuania. The ®rst trading session took place in July 1995, when trading began with a single price call auction, and by mid 1997 the trading system was extended to allow ad-ditional trading at a ®xed price following the initial call auction. In November 1997, the Ocial List of the most traded securities, together with the Second
2These percentages are calculated for the 120 trading sessions before and after the adoption of
List of less liquid companies, was transferred to a new trading mechanism where the call auction is followed by continuous variable price trading sessions. In January 1998, the Free List of all remaining securities listed on the RSE was transferred to continuous trading at variable prices. At the end of 1997, 51 companies were listed on the RSE with a total market capitalization of 198.8 million LVL (US$336.9 million).3
Establishing the ``form'' of a stock exchange has been a relatively straightforward task, but the evolution of the trading mechanism used at the RSE re¯ects the fact that realizing the ``function'' of a stock exchange has proven to be a much more dicult, incremental process. A general problem observed in stock trading in emerging markets is a general lack of liquidity, with most trading concentrated in only a small subset of the securities listed on the exchanges. Eleswarapu and Krishnamurti (1994) ®nd that on the Bombay Stock Exchange, for example, the overwhelming majority of stocks listed there suer from severe illiquidity with only infrequent trading, while active trading is concentrated in only the few largest stocks.
Re¯ecting this division of a small subset of stocks enjoying relatively active trading, the RSE has designated a group of stocks as the ``Ocial List''.4 Similar identi®cation of the most actively traded stocks is also observed in Tel Aviv, Prague, Warsaw, and Vilnius. Thus, the stocks which attract the highest degree of investor interest are eectively designated in the choice of list to which they are assigned. The securities issues traded on the RSE are separated into three dierent lists: the Ocial List, the Second List and the Free List. Listing requirements regarding information disclosure, size of an issue, free ¯oat, company pro®tability and trailing turnovers are more stringent for the Ocial List, and only the largest nine companies were listed there in May 1998. Smaller companies with a positive attitude towards stock exchange listing tend to be listed on the Second List, whereas the Free List, because of its minimal listing requirements, is preferred by the companies that are listed merely because the law on the privatization of the state owned companies requires it.
Although the RSE is the only ocial securities market in Latvia, trading can also take place in the OTC market where large blocks of securities from in-stitutional traders change hands. Volumes in the OTC market have been ap-proximately equal to turnover on the RSE. OTC trading, however, also includes trades by non-members of the RSE, as well as trades in non-listed companies. These ®gures need to be interpreted with a measure of caution as
3
The Latvian Lat (LVL) is unocially pegged to a basket of currencies. As of December 1997, the value of the Lat was US$1.00LVL 0.59 or LVL 1.00US$ 1.695.
4By European Union directive, the term Ocial List is used to designate the most important
they are broadly, albeit not directly, comparable. In 1997, cumulative market turnover on the RSE was 54.4 million LVL, whereas OTC market transactions for the same period totalled 43.9 million LVL. The large number of trades conducted OTC instead of on the RSE is a consequence of limited market li-quidity. The recent decisions of the RSE management board concerning block trade submission, registration and fees have encouraged institutional investors to direct most of their OTC trading in stock exchange listed companies back towards the RSE. During the course of the last year, OTC trading has lost momentum and was only 25% of the RSE turnover for the fourth quarter of 1997. In 1998 the relative number of trades conducted on the OTC market has steadily fallen, as the introduction of continuous trading at variable prices has brought a large number of trades back onto the exchange. This demonstrates that even though the form of a stock market has been put in place, fully re-alizing its function is far from an automatic process.
The evolution of the trading mechanism used on the RSE has been an evolutionary process beginning with a single call auction conducted once per week in July 1995. In the autumn of 1996 remote work stations were intro-duced for the entry of trade orders, and the number of trading sessions per week was gradually increased until by the ®rst quarter of 1997 all of the stocks listed on the RSE were traded ®ve days a week in a call auction with a single price ®xing. In determining the sessionÕs price at the call auction, the RSE trading system is obliged to follow the rules listed below in the given order of importance: (1) maximize turnover of the given security; (2) reach the smallest possible dierence between demand and supply; (3) minimize the dierence in price between that of the current session and the previous one. If an equilib-rium could not be reached at a daily price increase or decrease of 15% (10% after the inception of variable price method) from the weighted average price of a security at the previous trading session, a non-transactional price was pub-lished moving in either direction from the previous day's price. Because vir-tually all trading5has now shifted from the call auction to the variable price market and, as such, small volumes could easily cause large price swings ± the allowable price spread has been reduced to 10%, instead of 15% as before.
After trading activity started to increase, in mid 1997 the RSE introduced continuous trading at a ®xed price so that additional orders could be placed after the call auction was completed in order to reduce any imbalance between buy and sell orders at the ®xed price. Only those orders are accepted that have a price equal to the current call auction price.
Continuous trading at a ®xed price, however, did not improve the liquidity to the extent where its maintenance could be fully justi®ed. As the prices set in
5In the ®rst quarter of 1998 on average some 80±90% of all trades occur in the variable price
the call auction were frequently strongly favoured by only one side of the market, i.e., sellers or buyers, it was dicult to achieve many matching orders and clear the market. Therefore, the time limit assigned to this trading option has been reduced over time to 15 minutes today.
The ®xed price trading mechanism proved not to be the solution for in-creasing market liquidity as it has several drawbacks. First, an investor who submits an order for a particular stock has no idea, apart from yesterdayÕs price, of what might be the clearing price for the given stock and related stocks today. By placing a market order, investors could ®nd that their orders would be executed as long as any matching order, within the range of the price ¯uctuation limits, could be found in the system. For investors facing liquidity constraints, this could turn out to be the only option available for having their order executed. Moreover, once the price information for all stocks is made available after the call auction, investors may ®nd it reason-able to adjust their trades for particular stocks. Unfortunately, under the call method, such adjustments must be put o until the next trading day. Inves-tors are often reluctant to put large orders into the call auction as they can result in signi®cant and unjusti®ed price swings. Hence, they tend to break large orders into several smaller orders and trade them over a number of sessions, thereby bearing costs of illiquidity, delay and risk (see Amihud et al., 1997).
To address these drawbacks, in November 1997 the RSE introduced a new trading method for all stocks on the Ocial and Second Lists ± continuous trading at variable prices with automatic order matching, based on a public order book. This new system ensures the execution of an order at the best price, if available, at any given moment. The main features of the new system are (1) continuity, (2) a limit order book aggregating all order placement and trading activity and (3) automatic order matching. Trading in the system occurs over a 3.5 hour period with an allowed price ¯uctuation of 15% from the average weighted price of the security in the previous trading session.
The introduction of the new variable price method had been long awaited by the market participants and was expected to bring more liquidity and eciency in the stock market. Likewise, it was anticipated that a new trading pattern would attract foreign institutional investors. Given the improvement in li-quidity observed after the ®rst transfer, the 20 stocks from the Free List were transferred on 19 January 1998. The Baltic News Service (1998) reported on 15 January 1998 that both RSE ocials and market participants expected that the introduction of continuous variable price trading would improve the li-quidity of Free List stocks.
most probably did not share the expectation that continuous variable price trading would bene®t illiquid stocks, a belief which would be consistent with the market microstructure literature (see OÕHara, 1995). The RSE, however, adopted an approach similar to that reported by Amihud et al. (1997) in the development of Tel AvivÕs variable price trading mechanism, that is, ``a process of learning by doing''. Given the success of the new trading mechanism for Ocial and Second List stocks, there was a belief at the RSE that allowing the Free List stocks to trade only using the ®xed price mechanism was placing the less liquid stocks at a comparative disadvantage. Thus, with the support of the brokerage community, the RSE moved all listed stocks to continuous trading at variable prices.
Variable price trading commences after trading in both the call auction and continuous trading at the ®xed call auction price has been concluded. The market is not opened again with a call auction, but instead orders are simply added to the Public Order Book (POB). With several orders having the same bid or ask price, the order submitted earlier should be executed ®rst. All trades occurring under the variable price mechanism are the result of limit orders crossing. The bulk of trading on the RSE now takes place under the variable price trading mechanism.
Following the call auction, the highest limit order to buy becomes the best-bid price, and the lowest limit order to sell becomes the best-ask price. When an order to buy arrives at the exchange, the order is entirely ®lled at the best ask price only if the marketÕs depth at that quote is sucient. If the market depth is insucient, the order must be broken up and eectively walks up or down the limit order book as portions of trade are executed at dierent prices based on the availability of existing limit orders in the POB. Logically, if there are many limit orders in the POB close to the best bid±ask, the likelihood of exacerbated price moves on thin volumes is minor. As a convention, the ®rst criterion for selecting orders to be executed is price, and for orders with the same price, the criterion is the time of their placement in the POB.
3. Empirical results
3.1. The data
Table 1 presents RSE summary statistics for the period between 2 May 1997, when the RSE began trading on a daily basis, and 30 June 1998. Table 1 does not fully reveal the considerable variation in prices during this period as it shows a decline in prices in every subperiod. During the ®rst quarter of this period prices showed little variation as the Riga Stock Exchange Price Index (RICI) traded within a 90 point range between 705 and 795. During the second quarter of this period from 14 August 1997 to 21 November 1997, the RICI index rose from 746.68 to more than 1015 by early September in a summer rally, only to give back all of its gains in a subsequent correction to end the period at 700.50. Average turnover was the highest at LVL 317,598 per session, as was the standard deviation of returns on the index. The listing of the in-surance company Balta in early September 1997 was partly responsible for the sharp increase in trading volume, as it initially attracted substantial investor interest. During the third quarter of this period, prices drifted sideways and closed only marginally lower at 683.86. Thus, for the ®rst 75% of this period, there was a mild downward trend in share prices.
It was only during the fourth quarter of this period from 10 March 1998 to 30 June 1998 that a sharp decline in prices began following Moscow mayor
Table 1
Summary statistics for the Riga Stock Exchangea
Period Return per session (in %) Average turnover per
session (in LVL)
Mean SD
Full ÿ0:24 1.84 222,576
First half ÿ0:06 1.97 195,288
Second half ÿ0:42 1.68 250,053
First quarter ÿ0:06 1.14 74,654
Second quarter ÿ0:06 2.56 317,598
Third quarter ÿ0:02 1.21 232,553
Fourth quarter ÿ0:81 1.98 267,554
a
Summary statistics for 289 trading sessions on the RSE from 2 May 1997 to 30 June 1998. On 3 November 1997, two trading lists (out of 3) that form a major part of the market were transferred from call auction to the variable price trading mechanism. Daily return was calculated from equally weighted RICI. There were 8 stocks in the RICI index composition on 15 May 1997 and 13 stocks on 29 April 1998. Average turnover per session represents average market turnover on the RSE. The sample periods are as follows:
Yuri LuzhkovÕs call for a boycott of Latvian goods in response to Latvian police breaking up a demonstration by Russian pensioners in March. The expectation of a drop in Latvian exports to Russia led to a sharp decline in the share prices of food producers which have signi®cant trade relations with Russia and other members of the Commonwealth of Independent States, and this spread to a wider decline in the prices of Latvian equities.
All the data were obtained directly from the RSE. At the beginning of the period reported above, 36 stocks were listed on the RSE, 5 on the Ocial List, 16 on the Second List, and 15 on the Free List. Additional stocks have been listed throughout this period, and as of 30 June 1998, 62 stocks were listed. Ten stocks were listed on the Ocial List, including one cross-listed stock from the Tallinn Stock Exchange (Estonia), 19 stocks were listed on the Second List, and 33 stocks were listed on the Free List.
Stocks were transferred from the call method to the variable price method in two separate groups. The ®rst transfer was made on 3 November 1997 and consisted of seven Ocial List stocks and 21 Second List stocks. In January 1998 all of the remaining stocks listed on the RSE (the Free List) were also transferred to the variable price method.
In all the calculations pertaining to this study, we use trading volumes ex-pressed both in monetary units and by the number of shares sold. We take ®xed prices of the daily call auctions for the period before and daily average weighted prices for the period after. Weighted average prices are calculated including block trades6 to avoid exaggerated market depth in the liquidity ratio calculations. We use average weighted prices for the after period because stock prices are volatile on the RSE, and therefore weighted prices better represent the dayÕs trading than closing prices. Prices are adjusted for stock dividends.
3.2. Sample selection
Since there are listing announcement eects on securities values and liquidity (see, for example, Kadlec and McConnell, 1994), we exclude all the stocks that were introduced to the RSE within less than 120 trading sessions before the ®rst transfer of stocks to continuous trading at variable prices.7Thus, we wish to obtain a sample that is likely to re¯ect changes due to the introduction of the
6
We ®nd that stock prices from block trades usually tend to be somewhat lower than actual market prices for the same period.
7In order to account for any possible bias caused by the market
variable price trading mechanism rather than due to introduction of new shares on the RSE.
Our sample consists of 38 stocks that met the selection criteria. Based on pre-transfer values during the 120 trading sessions before the transfer, we considered each stockÕs share of total turnover in our sample, average turnover per session in LVL, and trading frequency as the proportion of sessions when a stock was traded, in order to partition our sample into high, medium, and low liquidity stocks (LLS). Table 2 presents the values for these parameters, as well as our division of stocks into these three groups. More detailed information about the companies included in our sample may be found in Appendix A (Table 5).
Those stocks that had a large proportion of total turnover in our sample, high average turnover per session in LVL, and high trading frequency relative to the other stocks in the sample, we denote by high liquidity stocks (HLS). Speci®cally, we de®ne HLS as having an average turnover per day greater than LVL 7000 and trading during at least 90% of the trading sessions. We de®ne LLS as having an average turnover per day of less than LVL 1000 and trading less frequently than 80% of the trading sessions. LLS had a low proportion of total turnover in our sample and low trading frequency before their transfer. Our division of stocks is consistent with a broad market consensus on the li-quidity distribution among RSE stocks.
Those stocks that fall between these two categories, i.e., those that occupy a ``gray zone'' between high and low liquidity stocks, we place in a middle group which we call medium liquidity stocks (MLS). The net result is that in a relative comparison, the HLS are clearly liquid, and the LLS are clearly illiquid. We want to emphasize that the dividing line between the groups involves a measure of arbitrariness, as the groupings chosen could potentially vary by the inclusion or exclusion of one or two stocks.
The seven stocks from the HLS group cumulatively account for 82.5% of total turnover in our sample for the 120 pre-transfer trading sessions, while the LLS group cumulatively account for 4.3%. Since the number of stocks in the MLS group is small, we leave the middle group as a ``gray'' zone and focus only on the high and low liquidity groups in our analysis. To compare our sample of 38 stocks with the entire list of stocks traded on the RSE, for the month of June 1998, our sample represented 99.5% of total market turnover in LVL, even though with 62 stocks listed on the exchange as of 30 June 1998, our sample accounts for only 61.3% of the number of securities listed on the RSE.
3.3. Findings
Table 2
Pre-transfer liquidity parameters for a sample of 38 stocksa
Rank Stock's
1 UNIB O 38.13 46584.18 100 2 STBR O 13.95 17044.72 99 3 RTFL O 7.37 9001.91 95 4 DPKR O 6.73 8220.73 95 5 VLSS S 5.97 7291.49 98 6 RKBV O 5.90 7211.79 100 7 KAIJ O 5.85 7151.60 90 Medium
liquidity stocks
8 JCF S 4.41 5377.87 92 9 LODE S 2.91 3548.13 84 10 SG95 S 1.54 1882.51 47 11 RJUV F 1.21 2301.76 78 12 MKRR S 1.07 1310.32 82 13 RAUG S 1.05 1290.33 49 14 LMR S 0.50 615.52 93
aPre-transfer summary statistics for a sample of 38 stocks. Each of the characteristics was calculated over
120 sessions period before the stock transfer to the continuous trading method. In the column ``List'', O, S, and F denote the Ocial, Second, and Free List stocks, respectively. Ocial and Second List stocks were transferred to the continuous trading on 3 November 1997; Free List was transferred on 19 January 1998. For Ocial and Second List stocks calculation period is 15 May 1997±31 October 1997; for the Free List stocks it is 25 July 1997±16 January 1998. Stocks are ranked according to the size of their sample shares.
b
Aggregate turnover of a stock for 120 sessions calculation period over aggregate turnover of the sample for the same period. [Note: Since sample shares are not calculated at one point in time, they may not add perfectly to 100%.]
cAggregate turnover for the calculation period divided by the number of sessions in this period (120). d
traded on the RSE compared to the ®xed price mechanism. As can be seen in Table 3, the average daily turnover per session for our sample of 38 stocks increased by 97.2%. For the 120 trading sessions prior to the introduction of variable price trading, the average daily turnover of the stocks in our sample was LVL 124,192, rising to LVL 244,846 for the 120 trading sessions after the new market microstructure was introduced.
This overall improvement in liquidity, however, obscures a more complex picture. We ®nd that for stocks with high liquidity before the transfer to the new trading mechanism, trading volumes more than doubled, while for stocks with low liquidity before the transfer, trading volumes fell to less than half of their pre-transfer levels. The level of trading of the MLS remained essentially unchanged before and after the new trading mechanism was introduced.
In addition to measuring the change in liquidity by observing the change in turnover (in monetary units), we also consider change in the average daily number of shares traded before and after the introduction of variable price trading. We can ®nd examples in the literature where dierent studies choose to concentrate on either number of shares traded, or on the monetary value of the shares traded. For example, the focus is on the number of shares traded in Shing-yang Hu (1997), while it is on trading volume in monetary units in Amihud et al. (1997).
Table 3
Summary statistics for the sample of stocks transferred to the variable price trading methoda
Period Average turnover per session (in LVL)
Sample High liquidity
Fullb 184,520 164,837 16,423 3,260
Beforec 124,192 102,506 16,326 5,360
Afterd 244,846 227,168 16,519 1,159
First beforee 77,321 62,718 9,114 5,489
Second beforef 171,065 142,295 23,539 5,231
First afterg 256,119 239,108 15,726 1,285
Second afterh 233,575 215,228 17,313 1,034
a
Summary statistics for the sample of 38 stocks transferred to the variable price trading method. Twenty-four of those stocks were transferred on 3 November 1997 and 14 stocks on 19 January 1998. Average turnover per session was calculated for each stock separately and then they were added for stocks belonging to the same group. Stocks are grouped according to the Table 2. T denotes the transfer day.
eFirst half of the ``before'' period.
fSecond half of the before period.
gFirst half of the ``after'' period.
In our study of the RSE, the change in the number of shares traded shows an even more dramatic increase in the improvement in liquidity for the high liquidity stock group. Following Moscow mayor Yuri LuzhkovÕs call for a boycott of Latvian goods in March 1998, there was a signi®cant decline in the RSE price level. Thus, if the number of shares traded had remained constant, we would expect to observe a reduction in the monetary volume of shares traded. However, we ®nd that the monetary volume of trading has more than doubled even as prices have fallen substantially.
Table 4 takes a closer look at the change in liquidity for the 38 stocks in our sample partitioned into high, medium, and low liquidity groups based on the 120 trading sessions prior to the adoption of variable price trading. Our con-clusions that the HLS group gained from the new trading mechanism while the
Table 4
Estimated liquidity eects of stock transfers to the new variable price trading methoda
Measure of liquidity Sample High
Increase:decrease 17:21 7:0 4:3 6:18
Signi®cant
Increase:decrease 11:27 5:2 2:5 4:20
Signi®cant
Increase:decrease 13:24 5:1 4:3 4:20
aEstimated liquidity eects for 38 stocks that were transferred to the new variable price trading
method. 24 of those stocks were transferred on 3 November 1997 and 14 stocks on 19 January 1998. Each of the measures of liquidity was calculated over 120 sessions before the transfer and was compared against the same measure of liquidity calculated over 120 sessions after the transfer. Signi®cance of change was tested at 5% signi®cance level. Those stocks that were not traded 120 sessions before their transfer are not included in the analysis. The transferred stocks are sub-divided into three groups according to their relative liquidity over 120 sessions before the transfer (see Table 2). Sign test was carried out for the LSS to test the binomial probability that change in li-quidity parameter is equally likely to be positive or negative, against the alternative hypothesis that it is negative. Note: For one HLS trading frequency did not change.
bAverage of the number of shares sold per session for a stock over 120 sessions.
cAverage of the turnover per session for a stock over 120 sessions.
dFrequency of trading expressed as a percentage of sessions when stock was traded, over 120
sessions.
*Signi®cant at 0.05.
LLS group lost hold whether we view liquidity as the monetary volume of shares traded, the actual number of shares traded, or the frequency with which stocks are traded (expressed in terms of the number of trading sessions where at least one trade occurs). Thus, although the improvement in market micro-structure led to a dramatic increase in trading, the bene®ts are not uniformly shared. The number of shares traded increased for only 45% of the stocks in our sample, the frequency of trading increased for only 37%, and the turnover in Latvian lats increased for only 29% of the stocks.
Five of the seven HLS experienced a signi®cant increase at the 5% level in their average turnover per session, whether measured in monetary terms or by the number of shares traded. The turnover for the other two stocks decreased in monetary terms, but their means before and after the transfer are not sig-ni®cantly dierent at the 5% level. Moreover, for these two stocks the number of shares traded increased. Interestingly, the largest relative increase was for the most liquid stock which saw its trading volume in monetary terms nearly triple, while the number of shares traded roughly quadrupled. The proportion of this stock in the total turnover of our sample of 38 stocks rose to 64.3%, compared to only 36.7% before the introduction of variable price trading. The share of total turnover of the HLS increased in our sample from 83% to more than 92%, which indicates that after the transfer there has been a further concentration of investor interest in just the few largest stocks.
Quite the opposite result was observed in the case of the LLS. Twenty of the 24 stocks experienced a drop in their average turnover per session, and for twelve stocks this decrease was statistically signi®cant at the 5% level. Only one stock showed a statistically signi®cant increase in trading volume at the 5% level. We tested the binomial probability that (1) the change in the average number of shares sold per session, (2) the change in the average monetary turnover per session, and (3) the change in the trading frequency, for the in-dividual stocks in the LLS group, is equally likely to be positive or negative, against the alternative hypothesis that it is negative. The null hypothesis can be rejected at the 1% level of signi®cance for the average monetary turnover per session and for trading frequency, while the null hypothesis can be rejected at the 5% level of signi®cance for the average number of shares sold per session. The proportion of the LLS group in the total turnover of our sample of 38 stocks dropped from 4.3% down to 0.5%.
following day. With the introduction of continuous trading at variable prices, prices could now adjust to re¯ect new information throughout the day, in-cluding the pattern of orders on both the buy and sell side of the market in the public order book.
Speculation in short-term price movements now became possible in those stocks which enjoyed high levels of liquidity as there was now a trading mechanism which allowed for a process of action and reaction with other market participants. Local brokers could now engage in daylight trading strategies, with no net position in a stock at both the open and close of trading on any given day. Thus, those stocks which previously attracted the most speculator and investor interest before the introduction of continuous trading at variable prices attracted even more interest. Those stocks in the LLS group now held little interest for speculation in short-term price movements, as the lack of orders meant that there was no ``action'' in these stocks. Over time, trading activity has concentrated in the single most active stock, Latvijas Unibanka, and this single stock accounts for approximately 80% of total trading activity on the RSE as of September 1998.
For the LLS group, the extremely small size of these companies helps to explain the lack of investor interest. For the 12 companies in the LLS group that are included in the Riga Stock Exchange (1998a) Guide to Listed Com-panies, as of year-end 1997 sales averaged LVL 1.6 million (US$2.7 million), total assets averaged LVL 1.2 million (US$2.0 million), and the number of employees averaged 202. Moreover, the above numbers are upwards biased as 12 companies of the LLS group were not even deemed of sucient interest to include in the1998 Guide to Listed Companies.
Although our sample of LLS represents less than 1% of the RSEÕs trading volume after the introduction of continuous trading at variable prices, these stocks accounted for 15.2% of the RSEÕs market capitalization as of year-end 1997. If we exclude the single stock that accounts for 40% of the RSEÕs market capitalization, then these LLS represent more than a quarter of the year-end 1997 market capitalization of all the other companies listed on the RSE. Furthermore, as stated in the Riga Stock Exchange (1998b)Annual Statistical Survey ± 1997, ``Last year the RSE has introduced the Free List, which pro-vides a possibility to relatively small companies to be quoted on the exchange.'' As all but one of the Free List companies are in the group of LLS (the one exception is in the medium liquidity group), we pose the question as to whether the function of the stock exchange is really being met for the shareholders in these companies.
their shares has sharply deteriorated. Furthermore, the number of ``losers'' is non-trivial when viewed from the perspective of the market capitalization of their shares. With even less trading than before the transfer, the prices of LLS should now be even less informative, as less information is re¯ected in their prices. Moreover, potential investors will be less willing to consider investing in these stocks if they know that it is unlikely that they can easily sell their shares due to an absence of buyers.
4. Implications
Stock market liquidity is widely held to be a function of active market participants, both liquidity traders and information traders, as described in the asymmetric information models by Copeland and Galai (1983), Glostein and Milgrom (1985), Glostein and Harris (1988) and Hasbrouck (1988). Unlike dealer markets, in auction markets it is the information traders who provide liquidity to the market. Under the premise that liquidity traders are in the market simply for portfolio adjustments relating to lifetime consumption stream optimization, auction markets that are not maintained liquid by a sucient number of information traders will attract little interest from liquidity traders. In markets with limited liquidity, higher trading activity will concen-trate around the more liquid stocks. Given that active information traders at the RSE concentrate their trading in only a few stocks, these are bound to attract more liquidity traders than other less liquid stocks.
Less actively traded stocks carry additional risks from the perspective of a market maker, as reported by Easley et al. (1996). There is a higher probability that any trade comes from an informed trader, and the wider bid±ask spreads that are observed for thinly traded stocks provide compensation for this greater risk of informed trading. In electronic trading systems based on limit orders (screen trading) such as the system adopted at the RSE, a trader placing a limit order in the Public Order Book is eectively writing a ``free option'' as described by OÕHara (1995). The result, as Easley et al. (1996) state is ``the almost universal failure of screen trading for inactive stocks.''
If an electronic auction market is predisposed to reduce trading costs and improve liquidity in large capitalization, actively traded stocks, such a trading system is not likely to bring the same gain in small-capitalization, thinly traded stocks. On the contrary, under an auction system, there are no bene®ts to be reaped by small-capitalization stocks as the loss of a market maker can not be entirely compensated by reduced trading costs and technological innovations. Because of fewer investors, small-capitalization stocks do not sell themselves, and they need to be marketed like any other product, ®nancial or otherwise. For large capitalization stocks, little, if any intermediation is necessary, while for small capitalization stocks substantial intermediation can enhance their liquidity.
Angel (1996) reports that a dealer market similar to NASDAQ provides a distribution channel for these securities, and its higher distribution costs gives brokers±dealers stronger incentives to create a pool of investors willing to trade such stocks. Angel also reports that NASDAQ has been a notable exception to the global pattern of unsuccessful markets for small-capital-ization stocks. Partially, its success can be related and explained by its structure that gives brokers±dealers strong incentives to market the securities in which they make markets and, thus, provide liquidity in them. Giving a preference to a higher cost channel like NASDAQ to market a stock is comparable to a manufacturerÕs decision to pay ``slotting fees'' to a su-permarket to obtain favorable shelf space for a product. The same argument applied in an emerging market context receives support from the Tallinn Stock Exchange (Estonia), which is largely a microcopy of its American counterpart, NASDAQ. We ®nd that stocks of similar size and character-istics listed on the RSE and TSE experience heavier trading in Tallinn as the brokers±dealers have adequate ®nancial incentives to quote and trade them.
Although a dealer-based trading system may oer some advantages in an emerging market setting, some caveats must be oered. Are the costs of a market making system justi®ed, especially in a setting where regulatory structures and institutions are likely to be weak? The principal of ``best exe-cution'' is dicult to regulate, and a loss of credibility is a possible cost if collusion among market makers were to be revealed. Also, although Tallinn reports much higher trading volumes than Riga, is all of this trading real or does it re¯ect brokers trading solely on their own accounts? Furthermore, stocks without at least two market makers in Tallinn are traded in a Public Order Book without automatic order matching, and in Riga no brokers ex-pressed interest in being market makers for the less liquid stocks listed on the RSE.
companies were listed in Prague, 42 in the ``Main Market'', 51 in the ``Sec-ondary Market'', and 1535 in the ``Free Market''.8One year later at year end 1997, the number of companies listed had been reduced by 80% to only 320, with the reduction coming from the Free Market which saw only 217 stocks remain. A further adjustment was made in early 1998, where 35 stocks were removed from the Main Market to the Secondary Market so that only the ten most actively traded companies remained listed there.
In Riga, the listing of a company on the ``Free List'' provides no assurance that an active market will develop for the companyÕs stock, nor that mean-ingful price signals will be sent to both users and suppliers of capital. Thus, in an emerging market context, there is a need to ®nd a way for trading in small company stocks to move from form to function. Perhaps the optimal solution is to avoid listing companies where the function of the stock market has no chance of being ful®lled, as has been done in Prague, so that the public does not become disillusioned with the new structures of a market economy.
We believe that further research as to the design of an optimal trading system for inactively traded stocks in emerging markets is required. Our em-pirical ®ndings on the RSE clearly show that the introduction of continuous trading at variable prices has created a group of losers. The LLS in our sample (which are also small capitalization stocks) suered a dramatic erosion of li-quidity from the introduction of the new trading mechanism. Unlike other stock exchanges in Tel Aviv, Prague, Warsaw, and Vilnius where only the more liquid stocks have been transferred to continuous trading at variable prices, all of the stocks listed on the RSE were transferred to the new trading mechanism. Thus, Riga provides evidence that a dierent approach other than continuous variable price electronic trading should be used to improve the liquidity of thinly traded, small capitalization stocks listed on stock exchanges in emerging markets.
5. Conclusions
In this paper, we examine how a change in market microstructure in¯uenced the liquidity of stocks at the RSE. The paper extends previous research on changes to the market microstructure in emerging markets by detailing what happened when all of the stocks listed on the RSE were moved to continuous trading at variable prices. Other emerging markets have adopted a similar microstructure to improve liquidity, but only the most liquid stocks already
8Note that Main Market, Secondary Market, and Free Market in Prague correspond to the
trading on the exchanges were moved to the new trading system. We also provide a detailed description of the institutional trading structure at the RSE in order to provide a perspective on the computerized trading system developed by the French Bourse de Paris.Similar trading systems have been adopted by the newly established stock markets in the Czech Republic, Poland, Lithuania, and Latvia.
As reported by Amihud et al. (1997) in their study of the Tel Aviv Stock Exchange, we ®nd that the introduction of continuous trading at variable prices caused the aggregate volume of trading to double on the RSE. Thus, the change in market microstructure improved the overall liquidity of the market. A more detailed analysis, however, reveals that those stocks, which had high liquidity before being transferred to the new trading system, saw substantial increases in turnover. However, the stocks which we classi®ed as having low liquidity before the transfer to the new trading system became even more il-liquid. Although our sample of LLS (identi®ed on an ex ante basis prior to the adoption of the new trading mechanism) accounted for 15% of the RSEÕs market capitalization at the end of 1997, these stockÕs share of total turnover on the RSE fell to less than 1% of trading on the RSE.
Thus, we argue that there was a group of losers as well as a group of ``winners'' from the change in market microstructure. In the aggregate, the liquidity eects of continuous trading at variable prices was positive, but if an objective is to enhance the liquidity of smaller companies listed on emerging market stock exchanges, other approaches need to be considered. Our ®ndings on the change in liquidity for the stocks which already had low liquidity before the transfer to the new trading mechanism provides evidence that an alterna-tive trading mechanism for the small company stocks listed on the RSE is required.
The failure of continuous trading at variable prices for the LLS on the RSE has been recognized, and on 3 December 1998 the RSE decided that eective 4 January 1999, Free List stocks would no longer be traded at variable prices. Thus, less than a year after the adoption of the new trading mechanism for Free List stocks, these stocks once again trade only at the price established in the daily ®xed price call auction.
Acknowledgements
Appendix A
Table 5 presents the company facts for the sample of 38 stocks.
Table 5
Company facts for the sample of 38 stocks
Ticker Name Listing date Industry
UNIB Unibanka 16-Jan-96 Banks ± regional
STBR Staburadze 2-Dec-96 Food & Grocery Products
RTFL Rigas TF 30-May-96 Shipping and Ports
DPKR Daugavpils PKR 8-Feb-96 Vehicle Components
RKBV Rigas KB 5-May-97 Engineering Contracting &
Shipbuilding
KAIJ Kaija 25-Jul-95 Food & Grocery Products
VLSS Valmieras SSR 24-Feb-97 Building Materials
JCF Jekabpils CF 19-Dec-96 Food & Grocery Products
LODE Lode 14-Oct-96 Building Materials
SG95 Salacgriva 95 17-Oct-95 Food & Grocery Products
RJUV Rigas JUV 16-Jun-97 Diversi®ed Consumer Products
MKRR Mangalu KRR 15-Aug-96 Engineering Contracting &
Shipbuilding
RAUG Rigas raugs 19-Sep-95 Food & Grocery Products
LMR LMR 24-Oct-95 Commercial Vehicles
STMR Strencu MRS 10-Oct-95 Forestry
VZKK Ventspils ZKK 29-Jan-97 Food & Grocery Products
RALU Rigas alus 25-Jul-95 Beverages ± Beer
VLDZ Veldze 14-Nov-96 Beverages ± Beer
ROJA Rojas ZKR 2-May-96 Food & Grocery Products
LTTL Latvijas tilti 2-May-96 Rail & Road
TLMR Talsu MR 31-Oct-95 Forestry
MISA Misas KF 17-Oct-96 Mining & Extractive
JBK Jelgavas BK 5-Sep-96 Building Materials
NART Naruta 3-Oct-95 Food & Grocery Products
KRA1 Kurzemes A1 31-Oct-96 Furnishings & Floor Coverings
BRAS Brasa 8-Feb-96 Furnishings & Floor Coverings
GRZV Grobinas ZV 14-Jul-97 Agriculture & Fishing
VITR Vitransauto 25-Jul-95 Rail & Road
OGMR Ogres MR 21-Nov-95 Forestry
AKTA Akta 23-May-96 Household Appliances & Tools
SNB Saldus NB 25-Jul-95 Oil Services
DGMR Daugavpils MRS 31-Oct-95 Forestry
SAMR Saldus MR 14-Nov-95 Forestry
SAUB Sauriesu BK 1-Jul-97 Building Materials
ROTA Rota 27-Nov-95 Printing
LZKR Liepajas ZKR 25-Jan-96 Food & Grocery Products
JSTA Jana seta 24-Oct-95 Printing
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